Icu Medical Inc/De Q4 FY2022 Earnings Call

Good day and welcome to the ICU Medical Fourth Quarter 2022 Earnings Conference Call. Please note this event is being recorded. I would now like to turn the conference over to John Mills of ICR. Please go ahead.

Good afternoon, everyone. Thank you for joining us to discuss ICU Medical's financial results for the fourth quarter and full year of 2022. On the call today representing ICU Medical is Vivek Jain, Chief Executive Officer and Chairman; and Brian Bonnell, Chief Financial Officer. We have a presentation accompanying today's prepared remarks. To view the presentation please go to our Investor page and click on Events Calendar and it will be under the fourth quarter 2022 events. Before we start our prepared remarks, I want to touch upon any forward-looking statements made during the call, including beliefs and expectations about the company's future results. Please be aware they are based on the best available information to management and reasonable assumptions. Such statements are not intended to be a representation of future results and are subject to risks and uncertainties. Future results may differ materially from management's current expectations. We refer you to the company's SEC filings for more detailed information on the risks and uncertainties that have a direct bearing on operating results and financial position. Please note that during today's call, we will also discuss non-GAAP financial measures, including results on an adjusted basis. We believe these financial measures can facilitate a more complete analysis and greater transparency into ICU Medical's ongoing results of operations, particularly when comparing underlying results from period to period. We've also included a reconciliation of these non-GAAP measures in today's release and provided as much detail as possible on any addendums that are added back. And with that, it is my pleasure to turn the call over to Vivek.

Thanks, John. Good afternoon, everybody, and we hope you're well. We could not be happier that 2022 is over. We are operationally running better and getting back to serving hospitals with at least an equal balance of time between internal self-help versus external customer focus. At a high level, the macro environment is easing a bit with finally some relief in the economic volatility in the supply chain that we've been talking about for six straight quarters. Freight, fuel, and foreign exchange started to trend in a better direction at the end of Q4. And while raw material and rollover labor inflation is real, at least some of the global surge pricing has retreated albeit above historical levels. U.S. and international demand was stable in Q4 with the U.S. having the same trends as Q3 in admissions with lower acuity. Like everyone in our industry, we want to start first by thanking all of our customers and their frontline workers for trusting us to serve you during these times. We cut a lot of the boilerplate out of the script today and we'll use the time to address the following: the results for legacy ICU and compare the full-year results to our original expectations at the beginning of last year, explain Smiths Medical's revenues for Q4, confirm our reporting alignment starting in 2023, recap our substantial earnings miss in 2022, discuss short-term, medium-term, and permanent recovery prospects, update on normal housekeeping items, and outline our key short-term priorities before Brian takes us through the financials in more detail. I'll summarize Q4 2022 whole company results and then discuss each of the businesses. We finished the quarter with $565 million in adjusted revenue. Adjusted EBITDA came in at $96 million and adjusted EPS was $1.60. We had a comparable quarter of investment into the business, largely about inventory build that Brian will describe. Gross margins were influenced by a high rate of spend to improve the service levels of Smiths Medical, and we had restructuring and integration costs that will reduce in 2023 as we focus on working capital and free cash flow like we did for many years. Currency was a net headwind for the quarter but did improve towards the end of the quarter. So let me start with legacy ICU Medical, where we had $313 million in revenue, which was down 2% on a constant currency basis and down 5% reported. Now with the minimal COVID impact in Q4, U.S. demand across all product lines was good. The quarter started out a bit softer in October but was very healthy in the last two months. However, a little more explanation is required here on two items. First, like a few other companies, we did have an accrual related to certain historical potential Italian tax liabilities for IV consumables and IV systems, which was somewhere between 2% to 3% of revenue. Second, we had a shortfall in IV solutions, mostly due to Pfizer being down on one remaining product format that they provide to us. As Brian will explain, neither of these had any material impact on earnings as we had some offsets on the first issue and IV solutions margin contribution is limited currently. Starting as usual with Infusion Consumables, which is our largest business. Infusion Consumables had revenues of $141 million, which was flat sequentially and down 2% constant currency, down 5% reported year-over-year, again impacted by previous comments. Going a bit deeper, our U.S. results were very solid in Q4 with our best quarter in the last two years. For the full year, we finished at $567 million in revenues, with minimal oncology growth as we were capacity constrained until very recently. Final annual results showed growth of 5% constant currency, in line with our comments on this call last year of mid-single digits. That is the largest our business has ever been and essentially all the supply chain and product constraints that hit us after a strong operational 2021 are reaching resolution for the legacy ICU portfolio. We have just gotten back to stability and a good focus on our clinical impact. Some of our customers were talking about their clinical improvements in our mutual areas of focus on their earnings calls last week. Moving to Infusion Systems, which is primarily our LVP pumps and associated dedicated sets. This business yielded $89 million in adjusted revenue, which was an increase of 1% on a constant currency basis or a decrease of 4% on a reported basis. Dedicated disposables were average in Q4 with the lower acuity in hospitals, but we had a good hard work quarter. We continue to believe, as we said on the previous few calls, that customer attention is back with bandwidth to have real discussions as some fatigue from COVID is passing and the acceptance of inflation and the cost of nursing, etc., have been internalized. Yes, the stresses of the current environment do make it a bit bumpier for decision-making, but we don't believe over the medium term, relative to our size, there's any change to our competitive opportunity, and we are focused on commercial execution here. For the year, the business unit finished at $351 million with over $10 million in currency headwinds, which aligns with our comments of $360 million or so on this call last year, with the largest base of LVP pumps in the market we've ever had. Our Plum platform did win the best-in-class ranking for multiple years in a row now, and we had the best year of competitive installations. We look forward to a more action-oriented market. Finishing the business unit discussion with Infusion Solutions. We had $71 million in adjusted revenues, down 7% on a year-over-year basis. This was primarily due to a single product family that we have been sourcing from Pfizer Rocky Mount over the last year or so, where we experienced a supply interruption and, to a much lesser degree, a few product shortfalls in our own operations. These results had minimal impact on company earnings as this business unit has disproportionately absorbed the majority of inflation at legacy ICU. We'll skip the whole boilerplate today on rational markets, etc. The short story for IV solutions, where we are the global number four player ex-Japan, is essentially the value of the product and its pricing are out of line. Investors can review the situation of the larger public players on their own. Okay. Let me move to the Smiths businesses. The Smiths Medical revenues came in at $252 million, with Infusion Systems at $99 million, Vascular Access at $75 million, and Vital Care at $77 million. We had productivity gains on a per-day basis shipping again. The message here is Infusion Systems and Vital Care had the best quarter since we've owned the business, and Vascular Access continues to be a work in progress, as we've mentioned. I'll come back to tie out the whole revenue picture on Smiths versus history momentarily, but just to comment on how the fulfillment of these products feels to customers is much better. Back orders, defined by improved service and clearing out of panic ordering, have decreased more than 65% since the challenges of last Q2. That has enabled us to be more reliable for customers and to finally engage on rebuilding trust and service as the products have always been well linked. From a big picture perspective on Smiths revenues, in our recent investor deck, we've tried to simply lay out the revenue variances for Smiths as compared to historical results. Smiths 2022 was about $150 million below normalized historical results ex-COVID. $50 million of that was currency FX, and the balance was roughly down $30 million in infusion systems, down $20 million in tracheostomy and patient warming, both of which we would call self-inflicted challenges, and down $40 million in Vascular Access, which is more a combination of self-inflicted and competitive challenges. It's worth noting that the Vascular Access products are the most synergistic with our core legacy ICU consumables business, and we believe we have a right to win here over time. In terms of this year, we foreshadowed on the last call and showed at the January IR conference how we would expect to realign our reporting business units. Our largest business will be consumables, which would contain legacy ICU IV consumables, most of legacy Smiths Medical vascular access, and tracheostomy. We would expect this business to be a mid-single-digit grower in 2022, like ICU consumables has been, with some puts and takes within the business unit. Consistent with the last call, production and operations for this pillar have improved with work needed on the Vascular Access commercial execution. The second business will be an Infusion Systems unit containing all legacy ICU IV pumps combined with most of the legacy Smiths Medical Infusion Systems business unit and the associated dedicated disposables. We think service levels and quality for most of this pillar should be improved in 2023 and would expect it to be a mid-single-digit grower also. This business captured almost all the capital sales of the company and a reminder that that’s less than 15% of total company sales and includes software service accessories, etc. The third business will be Vital Care, combining legacy ICU IV solutions, Critical Care, and the remainder of what is in the legacy Smiths Medical Vital Care business unit. We would expect that business to be flat, plus or minus a little. These revenue estimates assume no deterioration in the current level of healthcare utilization and the adoption of the recent EU MDR legislation allowing for MDD certificate extensions. These are our expected growth rates even when not adjusting for our exit from the Indian market and from China pumps, which equaled about $15 million in revenues or another point of growth in the first two pillars. So that's our view of revenues, and now let's move to earnings. Our miss in 2022 on earnings was painful, to say the least, and on the order of $100 million EBITDA from our original expectations. While painful, I did want to spend a moment walking through that bridge and it sets the stage for the comparison to this year's expectations and the value discussion regarding which of these are solvable over the medium term by normalizing to historical revenue levels and share recapture, price, and which are permanent hits to value. The two largest drivers of variance to earnings in 2022 were freight and logistics costs and foreign exchange currency, at over $50 million of EBITDA combined. Those were followed by Smiths revenue shortfalls, which cost at least another $30 million in EBITDA, and then surge pricing and inflation, which was also a $30 million-plus hit to EBITDA. Those were collectively offset by the achievement of more synergies, which brought the net back to $100 million. A good portion of this is reflected in our gross margin rate, which Brian will go through in more detail. A number of these items do start to improve in 2023, but continuing and rollover inflation is real, and we don't want to make a mistake given what we went through last year. Our current midpoint of the guidance range for EBITDA in 2023 is $400 million, with EPS generally in line with 2022 due to increased interest costs, as we talked about in last month's investor meetings. We believe revenue growth will be acceptable for our two highly differentiated businesses, but we still have work to do to offset inflationary effects and smooth out the production operations. We spared no expense last year in the supply chain, raw material procurement, etc., and that shows in inventories, which positions us well to the customer, but there are some knock-on impacts of smoothing out the production environment. Just a few notes on the housekeeping front, then I'll come back to priorities and value. On quality, nothing new on the pump decisions we explained in the last two calls. We have been going through our normal scheduled series of notified body inspections. What is new is an FDA inspection, probably a bit earlier than we've anticipated. We've made progress in addressing the root causes of the Smiths Medical warning letter received in late 2021, but we still have more work to do. So hopefully, these inspections serve as a good checkpoint to the state of progress we've made after only owning the business for 13 months. This part feels very similar to Hospira and our collective previous experiences, and we have the right people who have been through the exact same experiences, and our team is fully embedded into the operation. Same speech on the warning letter; the existence of a warning letter, while undesirable, is the regulatory agency trying to move the ball forward, and we talked about how these regulations give us the right to participate. We believe we're making progress in solidifying the foundation and hope to be in a position where we can demonstrate further progress as soon as possible. Again, regardless of where it appears on the P&L, we're spending heavily here, so making progress is extremely important. On the operational issues, I think we can stop talking about this now. We just need to focus on running a predictable production network. Given that there is a new topic, we will start talking about this year as we're more stable, and that is separation and integration. Unlike the Hospira transaction, where a lot of this was a one huge step activity, simultaneously separating and integrating systems, the work here will happen in two steps. Over the next few months, we'll separate IT systems from Smiths, giving us full control of the support and specs, and then later in the year and into next year, undertake the actual integration of the business. These are important steps because like Hospira, they allow for the next level of synergy capture across the manufacturing network, supply chain, and functional support areas. We did well for Hospira, and we will try to make system separation or cutover activities happen at the beginning of quarters in case of any knock-on impacts, but we wanted to mark that they were happening. We have a clear sense of our priorities for 2023. I'd summarize those as: deliver revenue growth as expected in our differentiated business units while progressing the key product platforms; progress and potentially resolve items and ensure quality for patients and high compliance for regulatory authorities, respectively; focus on cash flow again, by improving working capital and addressing all the available items on the P&L, whether above or below the line. We have the groundwork via separation and integration for capture of the remaining synergies and rationalize the portfolio, which becomes easier after separation and stability. To bring it back to some of the self-help and thoughts on value creation before Brian takes us through the financials in more detail. There are a number of self-help items that are available to us over the medium term to improve our earnings performance outside of revenue growth. I'll highlight the top three that are on our mind again, and they are largely all about longer-term gross margin improvement. The first is reducing the $240 million we spent in 2022 on freight and logistics. We've assumed some improvements for 2023, but medium-term, these costs need to continue to be reduced. The second is capturing the next wave of synergies in manufacturing, supply chain procurement, real estate, and functional support over time. That's why moving our separation forward from Smiths and away from Smiths and beginning our integration is so important. The third may be the smallest of the list, but it's getting to be a level-loaded and smoother manufacturing operation. We do believe there's $1 to $2 in earnings per share by getting these items right over the medium term. If we reflect on what we did with legacy ICU by profitizing our core business, even after taking on substantial inflation since early 2021 with a lot less margin from IV solutions, we believe we can execute this list. In terms of revenue and portfolio fit and how that comes together with value creation, clearly, whether it's a return to historical levels due to consistent supply or share recapture, the NPV of revenue increases is high as these are very sticky categories if one can avoid the self-inflicted harm that led to losses. There are a number of important U.S. contracts that do come up for renewal and repricing in 2024. On the portfolio, we continue to believe that we have strong individual assets in the specific underlying categories. We believe there are a number of Smiths businesses that have similar growth and economic traits to the legacy ICU consumables businesses. And while we don't want to give a hard average to earnings, we fully acknowledge we lost time. We did want to at least make it clear that there are a number of items over time that get us beyond our original expectations. Interest rates hurt us $1 a share right now, but all the items we just ran through do help build value back and get our profitability levels closer to our expectations. We're getting back to the aggregate positioning of the combined portfolio and its relevance for customers and their reactions. Yes, the situation is harder than we expected, but the customer logic continues to make sense. Like with the Hospira transaction, we need to change the conversation from the historical perception to demonstrating our value through innovation and service. These portfolios make sense together, and we are working on how to integrate them either literally or economically when sensible. And we do believe more doors are being opened as a result of having a broader set of items that are mandatory for care. We get that this needs to show up on the P&L to prove that value. For legacy ICU, our most differentiated businesses ended 2022 larger than ever with appropriate profitability levels. That core premise of the Smiths transaction is to enhance the product offerings for these exact categories that drive our returns, as well as add logical adjacencies predicated on the same characteristics of sticky categories, low capital intensity single-use disposables, opportunities to innovate and participate in a logical industry structure that can deliver that revenue and value growth we want to. The construction of the Smiths portfolio was logical and frankly, why it survived over all the years. While the pandemic introduced substantial volatility, strategically, we do think the weaknesses it exposed in the healthcare supply chain add to the argument for all participants to be healthy and stable, which has been our commentary since we became a full-line supplier. Smiths Medical also produces essential items that require significant clinical training, hold manufacturing barriers, and in general, are items that customers do not want to switch unless they have to. The market needs Smiths Medical to be a reliable supplier, and the combination positions us better. Our company has emerged stronger from all the events of the last few years. We've gotten knocked down a bit, but we see the hill to run up again together with our new colleagues to drive value out of the combination. Thank you to all the customers, suppliers, and frontline healthcare workers as we improve each day. Our company appreciates the role each of us has to play. And with that, I'll turn it over to Brian.

Thanks, Vivek, and good afternoon, everyone. To begin, I'll first walk down the P&L and discuss our results for the fourth quarter and then move on to cash flow and the balance sheet before wrapping up the discussion with our guidance for 2023. So starting with the revenue line, our fourth quarter 2022 GAAP revenue was $578 million, compared to $341 million last year, which is up 70% on a reported basis, reflecting the impact of the Smiths Medical acquisition. For your reference, the 2021 and 2022 adjusted revenue figures by business unit can be found on Slide number 3 of the presentation. For the legacy ICU business, adjusted revenue for the quarter was $313 million compared to $330 million last year, which is down 2% on a constant currency basis and down 5% on a reported basis. Infusion Consumables was down 2% constant currency and down 5% reported. Infusion Systems was up 1% constant currency and down 4% reported, while IV Solutions was down 7% on both a constant currency and reported basis. Note that the Q4 revenues for legacy ICU consumables and infusion systems were negatively impacted by a one-time revenue reserve related to the Italian government payback provision. This legislation, which was originally passed back in 2015 but only recently implemented, requires companies who have supplied medical devices to public hospitals in Italy to reimburse a portion of any budget overruns each year. Although we, along with others in the industry, plan to appeal the enforceability of the law and the underlying reimbursement calculations, we established a reserve during the quarter for amounts we could be required to pay going back to 2015. While this reduced our legacy ICU consumables and infusion systems' Q4 growth rates by 2 to 3 percentage points, the impact on revenues and earnings at a consolidated company level was minimal as it was mostly offset by one-time revenues within the legacy Smiths Medical business. After considering the Italian government payback provision, we were pleased with the results for the legacy ICU Consumables and Infusion Systems businesses compared to a very strong Q4 2021 that benefited from the Omicron/COVID surge. For the fourth quarter, the Smiths Medical business contributed $252 million in revenue. Compared to the third quarter, this represents a sequential quarter decline of $10 million. However, as we noted on our last earnings call, the Smiths Medical historical financial reporting calendar resulted in five additional business days during the third quarter, and we estimated that those five additional business days accounted for approximately $20 million of additional revenue. Adjusting for the additional days would imply a sequential revenue increase of approximately $10 million from Q3 to Q4. This underlying increase was the result of continued operational improvements, plus the previously mentioned benefit of certain one-time revenues, mostly within the Infusion Systems business. Note that the legacy Smiths Medical results were not impacted by the Italian payback provision. As we've previously discussed, for the first year after the acquisition, we maintained the legacy ICU and Smiths Medical business unit reporting structure to provide transparency and insight into the underlying performance of the individual legacy businesses. But now that we have a full year of operating as a combined business, in 2023, we will migrate to our new three business unit reporting structure of Consumables, Infusion Systems, and Vital Care. Slide number 4 of the presentation highlights the key product lines that comprise these three business units and provides the 2022 revenues for each, which will serve as our baseline as we move forward. As you can see from the GAAP to non-GAAP reconciliation in the press release, for the fourth quarter, our adjusted gross margin was 36%. Relative to the third quarter, gross margin of 35%. This represents a sequential improvement of 1 percentage point, driven by a combination of price increases, along with modest benefits from lower logistics costs. But during the quarter, we continued to be impacted by the same items that have pressured margins all year. For the full year, our adjusted gross margin was 36%, whereas heading into 2022, we originally expected it to be 40% or 4 percentage points higher. While we've previously discussed the drivers of this difference which fall into a few distinct categories, it's worth recapping. The first category was increased manufacturing costs driven by raw material cost increases and labor rate inflation, which negatively impacted adjusted gross margin by approximately 2 percentage points. The second category was increased logistics expenses related to higher market prices for freight and diesel, as well as air freight and other forms of expedited shipping to customers incurred primarily to address legacy Smiths Medical operational challenges, which combined were worth an additional 2 percentage points. In the final category is foreign exchange, which had a 1 percentage point negative impact on adjusted gross margin for the year as a result of the strengthening U.S. dollar. These negative margin drivers were partially offset by improved pricing later in the year and some benefit from product mix. While we expect to meaningfully reduce our spending on expedited freight during 2023, and we could see some benefit from lower diesel prices, we believe the majority of the manufacturing cost increases and about half of the logistics increases are permanent in the short term, and we will have to offset these through a combination of operational synergies and price increases over the next few years. Adjusted SG&A expense was $107 million in Q4 and adjusted R&D was $23 million. Both of these were the same level as the third quarter and benefited from deferred spending and lower incentive compensation expense. Restructuring, integration, and strategic transaction expenses were $10 million in the fourth quarter and related primarily to integration of the Smiths Medical acquisition. Adjusted diluted earnings per share for the quarter was $1.60 compared to $1.82 last year. The current quarter results reflect net interest expense of $20 million, an adjusted effective tax rate of 22.1%, and diluted shares outstanding of 24.3 million. Finally, EBITDA for Q4 increased 50% to $96 million compared to $64 million last year. Now moving on to cash flow and the balance sheet. For the quarter, free cash flow was a net outflow of $23 million, which was in line with our expectations as we continue to invest heavily into the three key areas of the business that we highlighted for the past several calls. The first is higher levels of inventory to bolster safety stock and allow for onboarding of new customers. Here, we invested almost $50 million in additional raw materials and finished goods inventory during the quarter, most of which was related to the Smiths Medical product lines in order to protect our manufacturing operations from supply disruptions and to replenish our distribution channels to better serve customers. The second was quality improvement initiatives for Smiths Medical, and during the quarter, we spent $21 million on quality system and product-related remediation. The third area was the integration of the Smiths Medical business, where, as previously mentioned, we spent $10 million on restructuring and integration. Additionally, we spent $22 million on CapEx for general maintenance and capacity expansion at our facilities as well as placement of revenue-generating infusion pumps with customers outside the U.S. This brought our total CapEx spending for 2022 to $90 million. To wrap up on the balance sheet, we finished the quarter with $1.7 billion of debt and $214 million of cash and investments. Moving forward to 2023, Vivek already provided some guidance related to our revenue expectations for each of the businesses, so I'll cover the rest of the P&L and cash flow. Starting with adjusted EBITDA, we expect 2023 adjusted EBITDA to be in the range of $375 million to $425 million. The majority of the earnings improvement relative to 2022 is expected to come from revenue growth within the Consumables and Infusion Systems business units, plus the benefit of some gross margin expansion. This is offset somewhat by incremental spending, most notably in the areas of temporary IT expenses as we move off the TSA during the year, as well as higher compensation expense as we reset incentive compensation. While this guidance range is a bit wider than our typical approach, we believe it is warranted given the uncertainty in the current economic climate and the reality that the legacy Smiths Medical business isn't yet as stable and predictable as legacy ICU. For 2023 EPS, we expect to be in the range of $5.75 to $7.25 per share. The midpoint of this range is in line with our full-year 2022 EPS of $6.51 and reflects the following year-over-year puts and takes. The first is approximately $1.25 of increase from $40 million of additional EBITDA based on the midpoint of our EBITDA guidance range. This is offset by approximately $1 impact from $30 million of higher interest expense on the unhedged portion of our debt and a $0.25 impact from a more normalized tax rate in 2023. Moving along to the rest of the P&L, we expect 2023 adjusted gross margin to be around 37%, which is an improvement relative to 2022 by 1 percentage point, driven by a combination of the impact of price increases and a reduction in freight expediting and diesel costs offset somewhat by continuing labor inflation at the plants. We are planning for operating expenses to increase mid- to high-single digits, reflecting the previously mentioned temporary IT investments needed to separate from the Smith TSA, the impact of resetting incentive compensation plans, and general inflationary increases. Net interest expense is expected to be almost $100 million. The adjusted tax rate should be around 23%, reflecting our normalized tax rate. Finally, diluted shares outstanding are estimated to average 24.5 million during the year. Now on to cash flow. As mentioned earlier, during 2022, we invested heavily in additional inventory, quality system and product remediation, and restructuring and integration. During 2023, we expect to spend at similar levels for quality system and product remediation, and we should see a step-down in restructuring and integration spending. The most significant year-over-year improvement to cash flow is expected to come from slowing the build of inventory levels over the early part of the year and then maintaining or even slightly reducing those levels during the second half. This will allow us to get back to generating positive free cash flow in 2023. Finally, we expect our CapEx requirements in 2023 to be in the range of $100 million to $120 million. In summary, while 2022 was a very difficult year, the fourth quarter provided a glimpse of what getting back to normal can feel like. A lot of hard work and sizable financial investments have been made to stabilize the operations of the legacy Smiths Medical business. And while this work is not yet complete, our progress here allows us to shift some focus during 2023 to recapturing lost business as well as deeper operational synergy opportunities. Our progress to date also allows us to remain convinced of the longer-term opportunity, financial returns, and our ability to tackle the remaining issues. We look forward to providing updates on our progress. And with that, I'd like to turn the call over for any questions.

Our first question comes from Jayson Bedford with Raymond James.

Can you hear me okay?

Perfectly.

That was dense. There's a lot there. And I appreciate that.

So we were trying for thorough.

Yes. My head is exploding here with all of that. Just I guess maybe on the fourth quarter revenue, I get the, what, roughly $8 million decremental. But I think Brian mentioned this was offset by one-time revenue tied to Smith. Do I have this right? And then just as maybe a related question, what are you carrying in terms of Smiths backlog into '23? And is there any kind of backlog captured in what looks to be about 4% revenue growth in '23?

Yes, Jayson. On the first question, yes, that's correct. The amount you referred to was within the range. And we would say most of that impact was offset by some one-time revenues on the legacy Smiths Medical business, specifically within the Infusion Systems business of legacy Smiths Medical.

On the backlog question, it's been hard to triangulate, Jayson, how much of the backlog was real. It was a huge number, but even though we've worked it down, it's not like revenues went back up above historical levels. I think what was embedded in there was also, unfortunately, a lot of panic ordering, etc. A lot of those have fizzled out now that we've been supplying more regularly, so we're going to get a truer sense of what the real run rate is with recent losses, etc. At the current moment, probably on the order of $40 million or so of backlog into next year. That's kind of where it is right now. But I don't know that means additional revenue beyond what the normal rate is.

Okay. So sorry, the $40 million, is that incremental on top of what would be a normalized backlog?

No. I think backlog for us has just been like a proxy for customer service levels at this point. I don't think that I would say it's additional revenue. It didn't work that way this year as we worked on the backlog.

Okay. I think it was mentioned that price increases helped the gross margin in the fourth quarter and that will continue into '23. Is there any way to frame the size of the price increases and the impact that may have on the top line in '23 as well?

I don't think we want to get too specific; there are a lot of moving parts. I just think we've been doing what we should do given the inflation that we've taken and what other industry participants clearly have been doing, and I'd probably just leave it at that. We think we have good growth rates for Consumables and Infusion Systems for '23. A portion of that is priced.

Okay. And then maybe I'll ask one more and I'll let others jump in. But Vivek, you did mention the FDA inspection and I appreciate the transparency there. But just what is the kind of scope and what are they looking at? I assume this is a scheduled, every couple of year inspection, but is there anything kind of specific that you're looking at?

I think this is a follow-up to the items that got Smiths the warning letter in the fall of '21. We had instinctively thought it was going to be a little bit later. Every day later is just more time to prepare and execute. It's happening sooner, so it will be a good checkpoint to how much progress we've made over the last year certainly, but it was sooner than we thought. I'd rather be transparent about that.

Yes. Our next question comes from Larry Solow with CJS Securities.

I have a couple of follow-up questions for you, Vivek, particularly regarding Smiths. Putting the quality control issues aside, which I know are somewhat outside your control and hard to predict in terms of timing, I'd like to focus on service and order fulfillment, which have faced some challenges and you've been working to improve for several quarters now. I've noticed significant improvement in the last couple of quarters. Can you provide an update on where you currently stand? If we think about it in terms of a baseball game, are we in the middle of the inning? I'm interested in your perspective on fulfillment and related areas that are likely within your control, even if they may take longer than initially expected.

I believe we are making progress, and I recognize your concerns. We are currently at a midpoint in our journey. Our operations are improving, as evidenced by our silence on physical logistics issues. Our inventory has increased by $200 million, indicating production challenges. The key now is how we can reduce the inventory to appropriate levels. Additionally, we need to assess whether everything is functioning at the right cost. We invested significantly to strengthen our supply chain and better serve our customers to avoid losing market share, which affected our profit and loss statements in an environment of widespread inflation. Some costs, particularly labor in logistics and production, will remain. However, we need to address the manageable issues before stating that our operations are fully running efficiently. It's not only about service levels; we must also evaluate our operational efficiency. Our operating margin is crucial in relation to the categories we've acquired.

There are excess dollars that you may not be able to quantify today, but excluding the freight and other challenges to your earnings, there are additional expenses. As you mentioned, spending is occurring at any cost, which seems to affect both capital and operating expenses.

I mean that's why we tried to go through all that minutia in the script there because that's exactly the point we were trying to clarify.

And in that broad range of earnings, you mentioned that it aligns somewhat with our guidance, but is wider than usual. Is that strictly related to what you stated about Smiths?

It is basically Smiths' results, and then inflation on the solutions portion of legacy ICU to get that back under control. We don't want to go through what we went through last year, Larry. The world has not settled yet. A lot of these currencies still move internationally; they are still moving. We don't want to make that mistake.

Okay. I understand that due to competitive reasons, you can't discuss pricing in detail. However, it seems that your business is being disproportionately affected. You mentioned multiple times during this call that your solutions business is not even profitable, which is not sustainable. I'm curious about what can be said regarding this, especially since you referenced being the third or fourth largest provider. Are the other competitors simply waiting, or is there any movement on their part? It feels like across various healthcare sectors, contracts are being renegotiated, yet in your case, it seems dramatic that you can't break in for another 1.5 years. Is there any progress?

I believe this is a topic we should avoid discussing here. We have our own business to manage, and we will concentrate on that.

That's fair. Okay. Great. Last question, just on free cash flow, Brian. Can you give us some idea? It sounds like we certainly improved last year from a big usage. Is it going to be just modestly positive? Is there any more color on that? The second question is about debt reduction. I know originally, when the acquisition closed, we thought a couple of years to reduce it. Do you have any updated target on when you can lower leverage?

Yes. I mean on free cash flow, I think the potential range for '23 is a bit wide, just given the fact that we invested so heavily in '22. I think that's going to be largely dependent on how quickly we can get to the right inventory levels and moderate or even reduce them. You'll probably see most of that benefit come in the second half of the year. As it relates to debt paydown, I think what we just outlined in terms of guidance assumes no debt paydown this year. But I think, of course, depending on how quickly we get back to positive free cash flow generation will ultimately determine when we can begin to pay down debt. Not sure if it's this year, but we just need to get to positive free cash flow first.

Our next question comes from Matthew Mishan with KeyBanc.

Kind of a follow-up to that previous question. I guess, when is the IT implementation scheduled to occur? And how are you thinking about portfolio rationalization and potential asset sales ahead of that IT implementation?

Sure, Matt. This situation is different from our previous deals where we had to fully integrate and transition everything right from day one. Here, we will take control of the system and manage it independently, which is beneficial since there are still some uncertainties in the fourth quarter. This separation is expected to occur around April or May if everything goes according to plan. Once we are separated, we will have control and can decide how quickly to proceed with the integration, which is important to us for achieving the next level of synergies we discussed. We prefer to do this sooner rather than later, although it comes with a cost. It’s important to recall our experiences with Hospira. However, being separate provides us with greater flexibility on how to manage our portfolio, allowing us to decide which pieces can be divested or retained. In a broader sense, the systems are not the primary factor in generating value compared to business performance and returns, so while important, they are not the sole focus of our strategy.

Okay, that's reasonable. To clarify, you previously touched on this topic, so I'll rephrase my question. You're working with a wide range. I understand your desire to be cautious, especially considering the ongoing macroeconomic uncertainties. Could you identify two or three key factors that could influence a shift from the lower end to the upper end of your range while considering the significant elements at play?

If we start with the broader economic factors, certainly foreign exchange is something we saw in 2022 having a significant negative impact. This is an area that can significantly affect our results. Additionally, on the commercial front, there are likely some opportunities, particularly within the legacy Vascular Access business, where we could potentially regain some of that business and see an uplift.

We tried to give the exact bridge for the missing $100 million variance, Brian, with examples in gross margin. Some of the gross margins up are permanent; labor is permanent. Some of the raw material increases are absolutely permanent. Then there's some surge stuff that is going to go away. The macro on FX and fuel, but it always comes back to revenues. We have $100 million less of high-margin revenues that went away. We've got to figure out how to get those back. That's how we get the overall return to where we want it. We kind of say, what were those buckets of what was missing? You can make your own call on the individual components there and the market structures of those categories. The ones that we feel are self-inflicted, there's no reason we shouldn't be going out there to try and take those market shares back. The ones that have competitive challenges, we have to execute and win.

Is that separate? I think I heard you mention that you would maintain a higher level of inventory to assist with onboarding new customers. I'm curious if this means you aim to grow revenue from new customers in addition to your existing ones. With that higher inventory, do you believe you can regain some of the sales lost from current customers? Are these completely separate issues, or are they connected through the inventory?

Well, it's a little bit of what we experienced with Hospira, right? We bought a situation that was challenged, and we went on a global apology tour. If you want to get some pieces of business back, you do have to make commitments about your reliability and your ability to supply because people only left because they couldn't get the product from Smiths. We do have to show better levels of inventory, and we have to make some commitments around it. That's just putting more money into the transaction. We lost time and we cost a little more capital, but we have to get a return on that by getting the business back.

I hate to ask a near-term question like this, but it seems like you had a good November and December, and January and February seem relatively steady from an outside perspective. Is this the steadiest environment you have seen in a very long time? And is that translating to more confidence in the business?

I don't know if that's a short-term question. That is a question about how this feels versus 2021 and '22. I think, on the legacy ICU business, the Consumables business is the biggest it's ever been. That has compounded nicely. We feel okay. The LVP business, it's the biggest it's been since we've had it. We're still disappointed we didn't get as much as we would have liked over the last few years. I would say both those businesses have been reasonably predictable for the last 3, 4, or 5 quarters, and the issues that made them even slightly unpredictable, the lack of supply in oncology, etc., are all being improved. I don't want to say it's exactly smooth with the Smiths portfolio yet. We’ve had our control on it for 3 to 4 quarters. So yes, it is getting better each day, but there's still a lot of work to do on the Smiths portfolios. We'll judge that if we can get those lost revenues back.

This concludes our question-and-answer session. I would like to turn the conference back over to Vivek Jain for any closing remarks.

Thanks for your continued interest in ICU Medical. We're glad 2022 is over. We look forward to 2023 and we look forward to updating you very soon because Q1 call will be here before we know it. Thanks, everyone. Appreciate it.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.